What’s Wrong with Emerging Markets?

While the US markets are up nicely since the beginning of the year, emerging markets are down. What’s going on?  After all, China, Brazil, and other developing economies have the enviable trade surpluses, high growth rates, and excess reserves that the US doesn’t. Are the new “bankers to the world” who have been funding our growth by buying US Treasuries stalling before our eyes?

Recent data looks grim for emerging markets. This three month chart shows the big lag between the largest emerging market ETF, Vanguard’s VWO, and the S&P 500.

Source: Yahoo Finance. Enlarge chart here

Many experts are trying to explain (or explain away) this performance gap. (See the Investors Business Daily article, “Why Are Emerging Market ETFs Lagging So Badly?”.) There are plenty of theories to go around, from inflation to rising interest rates. Depending on the theory one accepts, the chart above could be an urgent warning to sell or a clear signal to buy.

In my view, it’s neither. I don’t even think it’s the right chart to look at.

A longer view of VWO versus the S&P (below) shows that the current lag in emerging markets is just a little more squiggling in an already very jagged line. Over the last six years, emerging markets equities have behaved about as one might expect, with both higher long-term returns and greater volatility than large cap domestic stocks. VWO is up 84% since 2005, even with its dramatic crater in 2008-09, while the S&P is barely in positive territory for the period.

Source: Yahoo Finance. Enlarge chart here.

By the way, VWO is just one of many emerging market investments. For instance, iShare’s EEM, (which, like VWO tracks the MSCI EAFE index), traces a chart similar to VWO. And DGS from Wisdom Tree is a dividend-oriented small cap emerging markets ETF with a current yield of 2.5%.

Too big to ignore

Emerging markets matter. Up from a miniscule share a decade ago, they now comprise about 26% of global market capitalization, based on the 20+ nations that index-maker MSCI classifies as emerging. Some predict this share to double by 2030.

Based on this rapid and continuing growth, emerging markets deserve the attention of investors. But the size of an allocation to emerging markets, in my view, should be based not on short-term data, but on long-term expected risk and return characteristics.  Holding emerging markets means you are ready to accept a higher level of expected risk in exchange for a chance at higher returns, and can endure the sometimes frenetic headlines and commentary that accompany volatile returns.

As always, diversifying among many asset classes helps to reduce exposure to poor short-term performance in any particular market segment, like the recent lag seen in emerging markets.

So what’s wrong with emerging markets right now? Nothing, in my view.  They are behaving in the short term as one might expect, with prices changing like the March weather.